The European Central Bank made the case on Tuesday for having state-backed ‘bad banks’ buy part of the 1 trillion euros of non-performing loans (NPLs) that are curbing lending and economic growth in parts of the euro zone.

THE EUROPEAN Central Bank is trying to bring down the amount of non-performing loans at the 127 large banks it supervises, handing out targets to the worst offenders, such as Italy’s Monte Paschi, and setting best practices for the rest.

But the market for bad debt is struggling to take off. The problem is the gap between the price at which banks can afford to sell and what buyers such as private equity funds are prepared to pay.

This is partly because buyers discount the time and cost of working out a bad loan, especially in countries where the judicial system is slow, such as Greece and Italy, and it is sometimes hard for them to value collateral.

Setting up asset-management companies (AMC) – bad banks like those created in Spain and Ireland during the 2008-2012 banking crisis – to buy some of those loans can help ease the pressure on banks and ignite the market, the ECB said.

“Many of the impediments to the creation of secondary NPL markets … can be alleviated by the establishment of a well-designed AMC,” the ECB said in a feature of its Financial Stability Review.

“A further argument for the establishment of an AMC relates to its ability to act as a market reservoir, which can soak up excess NPL stocks while impediments to NPL resolution are being addressed.”

The study echoes comments by ECB President Mario Draghi last summer — when the Italian government was negotiating a solution for Monte Paschi with the Commission — which have so far fallen on deaf ears.

In the study, the ECB argued such bad banks would not fall foul of EU rules against taxpayer bailouts so long as they bought loans at a “long-term economic value” set by national authorities and approved by the European Commission.

Such vehicles could also inject capital into a bank if it would have a capital shortfall in an “adverse scenario”, such as an economic downturn or market crash, as determined by its supervisor in a stress test.

Private investors would still have to bear the brunt of the “expected loss”, that is the difference between a loan’s value on a bank’s books and the price at which it was sold.

The ECB cautioned the solution would work best where loans are large and collateral easy to value, as in the case of mortgages, while it might be a poor fit for corporate loans, which are typically heterogeneous and smaller.